Brady Bonds

DEFINITION of Brady Bonds

Brady bonds are bonds that are issued by the governments of developing countries. Brady bonds are some of the most liquid emerging market securities. The bonds are named after former U.S. Treasury Secretary Nicholas Brady, who sponsored the effort to restructure emerging market debt.

The price movements of Brady bonds provide an accurate indication of market sentiment toward developing nations. Most issuers are Latin American countries.

BREAKING DOWN Brady Bonds

Brady bonds were introduced in 1989 after many Latin American countries defaulted on their debt. The idea behind the bonds was to allow commercial banks to exchange their claims on developing countries into tradable instruments, allowing them to get nonperforming debt off their balance sheets and replacing it with a bond issued by the same creditor. Since the bank exchanges a nonperforming loan for a performing bond, the debtor government’s liability becomes the payment on the bond, rather than the bank loan. This reduced the concentration risk to these banks. The program, known as the Brady Plan, called for the U.S. and multilateral lending agencies, such as the International Monetary Fund (IMF) and The World Bank, to cooperate with commercial bank creditors in restructuring and reducing the debt of those developing countries that were pursuing structural adjustments and economic programs supported by these agencies. The process of creating Brady bonds involved converting defaulted loans into bonds with U.S. Treasury zero-coupon bonds as collateral.

Brady bonds are mostly denominated in U.S. dollars. However, there are minor issues in other currencies, including German marks, French and Swiss francs, Dutch guilders, Japanese yen, Canadian dollars, and British pounds sterling. The long-term maturities of Brady bonds make them attractive vehicles for profiting from spread tightening.

In addition, the payment on the bonds are backed by the purchase of U.S. Treasuries, encouraging investments and assuring bondholders of timely payments of interest and principal. Brady bonds are collateralized by an equal amount of 30-year zero-coupon Treasury bonds. Issuing countries purchase from the U.S. Treasury, zero-coupon bonds with a maturity corresponding to the maturity of the individual Brady bond. The zero-coupon bonds are held in escrow at the Federal Reserve until the bond matures, at which point the zero-coupons are sold to make the principal repayments. In the event of default, the bondholder will receive the principal collateral on the maturity date.

Risk of Investing in Brady Bonds

While Brady bonds have some features which make them attractive to investors interested in emerging market debt, investors are exposed to interest rate risk, sovereign risk, and credit risk. Interest rate risk is faced by all bond investors. Since there is an inverse relationship between interest rates and bond prices, fixed income investors are exposed to the risk that prevailing interest rates in the markets will rise, leading to a fall in value of their bonds.

Sovereign risk is higher for debt issued by countries from developing or emerging countries, given that these countries have unstable political, social, and economic factors in terms of inflation, interest rates, exchange rates, and unemployment statistics.

Since emerging market securities are hardly rated investment grade, Brady bonds are classified as speculative debt instruments. Investors are exposed to the risk of the issuing country defaulting on its credit obligations – interest and principal payments on the bond. In view of these risks, emerging market debt securities generally offer investors a potentially higher rate of return than is available from investment-grade securities issued by U.S. corporations. In addition to the higher yield on Brady bonds, the expectation that the issuing country’s creditworthiness will improve is a rationale that investors use when purchasing these bonds.

Mexico was the first country to restructure its debt under the Brady Plan. Other countries soon followed including Argentina, Brazil, Bulgaria, Costa Rica, Cote d'Ivoire, the Dominican Republic, Ecuador, Jordan, Nigeria, Panama, Peru, the Philippines, Poland, Russia, Uruguay, Venezuela and Vietnam. The success of these bonds in restructuring and reducing the debt of participating countries was mixed across the board. For example, in 1999, Ecuador defaulted on its Brady bonds, but Mexico retired its Brady bond debt completely in 2003.

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A pre-funded bond is a municipal bond backed by Treasury securities deposited in an escrow account. Pre-funded bonds are issued by municipalities that wish to attain a higher credit rating for their debt.